The FOMC started raising rates 16 months ago, and there are two different explanations for why Fed hikes have not yet slowed down the economy in a meaningful way:
1) The Fed has not raised interest rates enough.
2) The lagged effects of Fed hikes take longer than we think.
The Fed does not know if the continued strength in the economic data is because it has not raised rates enough or if the lagged effects of Fed hikes take longer than usual. As a result, the FOMC’s approach is to keep interest rates elevated until the economy starts slowing down. Against this backdrop, a soft landing is not an option because the Fed will keep interest rates high until they get the economic slowdown required for them to turn dovish.
Even if inflation comes down and growth is still strong, the Fed will continue to be hawkish because of worries about strong growth causing a re-acceleration in inflation. The implication for markets is that a recession is a pre-condition for the Fed to stop being hawkish.
Source: Bloomberg, Apollo Chief Economist. Note: 500bps monetary policy shock in 3Q23.
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